Thesis

1. Operating income is defined to be revenues less operating expenses and should be before financial expenses (interest expenses, for example) and capital expenses (which create benefits over multiple periods). Specify at least two items that currently affect operating income that fail this definitional test and explain what you would do to adjust for their effects.

The two items that most directly contradict this definition of operating income are operating leases and R&D expenses, both of which are categorized as operating expenses. Operating leases are financial expenses and R&D expenses are capital expenses. To correct the operating income, we have to do the following:

* Take the present value of operating lease commitments, using the pre-tax cost of debt of the firm as the discount rate, and treat the present value as debt. The operating income has to be adjusted by adding back the operating lease expense and subtracting out the depreciation created by the operating leases.

* Specify the number of years before R&D can be expected to generate commercial products, collect R&D expenses from the past for that many years and then amortize them; straight line usually works. The remaining unamortized R&D from prior years can be considered the book value of the R&D asset, and operating income has to be adjusted by adding back the R&D expense from the current year and subtracting out the R&D amortization for the current year.

* 2.     Operating income can be volatile both as a result of the normal ebb and flow of business and as a result of accounting transactions (one time income and expenses). Should you smooth or normalize operating income and if so how do you do it?

If you plan to base your future operating income on current operating income, it stands to reason that you want to remove any items that are transitional (one time charges or income) or cancel out over time (exchange rate or pension fund gains...